Liberty Tax Inc (NASDAQ:TAX) is trading with a trailing P/E of 15.8x, which is lower than the industry average of 24.5x. While this makes TAX appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Liberty Tax

What you need to know about the P/E ratio

A common ratio used for relative valuation is the P/E ratio. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.

P/E Calculation for TAX

Price-Earnings Ratio = Price per share ÷ Earnings per share

TAX Price-Earnings Ratio = 14.4 ÷ 0.914 = 15.8x

On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to TAX, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 15.8x, TAX’s P/E is lower than its industry peers (24.5x). This implies that investors are undervaluing each dollar of TAX’s earnings. Therefore, according to this analysis, TAX is an under-priced stock.

Assumptions to watch out for

However, before you rush out to buy TAX, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to TAX, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with TAX, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing TAX to are fairly valued by the market. If this does not hold, there is a possibility that TAX’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to TAX. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.

Are you a potential investor? If you are considering investing in TAX, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.